New EU Rules on Environmental, Social and Governance (ESG) Disclosure

In 2020 in Europe and beyond, asset managers turned to the integration of environmental, social and governance factors in their investment decisions, and 2021 looks set to continue the trend. The EU’s new Sustainable Finance Disclosure Regulation (SFDR) entered into force on 10 March 2021.

Under the new rules, funds that promote sustainability in their investment process will have to substantiate that promotion, depending on the level of their ESG-related ambitions. The focus of the regulation is transparency on whether and how a firm applies ESG standards. The EU has created a tiered regime, with sets of basic and enhanced disclosures. Basic disclosures are required for all firms in scope (e.g. fund managers, portfolio managers and investment advisers), which will need to explain whether and how their investment decisions, as well as remuneration policies, integrate sustainability risks (i.e. ESG risks which could impact on the value of their investments). They will need to make these disclosures available on their websites and in their pre-contractual documents, including the private placement memorandum.

Firms that do not wish to trigger the enhanced disclosures of the SFDR will need to carefully balance their statements: enough to explain how they integrate ESG risks that may negatively impact on the value of their investments, but without promoting environmental and social criteria in a manner to qualify their funds under the enhanced disclosure regimes of Article 8 of SFDR (funds that promote environmental or social characteristics) or Article 9 of SFDR (funds with sustainable investment as their objective-broadly, impact funds). Such funds will need to make extensive disclosures and satisfy ongoing reporting requirements on their approach and the attainment of such characteristics or objectives.

The SFDR also introduces the concept of “principal adverse impacts” of investments on sustainability factors. Unlike the sustainability risks, principal adverse impacts are those risks which the investment could present on sustainability factors, namely the investment’s externalities such as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters – regardless of any financial impact.

Smaller firms (broadly, those with fewer than 500 employees) will be able to opt out of the principal adverse impact disclosures. For firms which do not opt out, disclosure of principal adverse impacts will be mandatory across their entire portfolio. Managers should consider carefully whether they are willing and able to obtain, evaluate and report on the prescriptive data required by SFDR for principal adverse impacts, and disclose “actions taken” (if any) year by year to address the adverse impacts. See our note on the recently published Level 2 rules accompanying the SFDR.

The SFDR is certainly an ambitious regime, designed to apply to all EU managers (regardless of strategy) and currently taken to apply to non-EU managers that market their funds in the EU under the national private placement regimes. By applying prescribed sets of disclosure, it may well address investor “green-washing” concerns (more prevalent in the retail fund world) and might form the basis for regulated investors to channel capital to sustainable or impact investing funds. The effectiveness of the disclosure required by larger managers in relation to “principal adverse impacts” across all of their portfolios and products in addressing, for instance, climate change risks, remains to be seen.

Cross Border Distribution of Funds

Further changes come with new rules on the cross border distribution of funds, becoming effective in member states in August of this year. The new legislative package provides a helpful pan-EU definition of “pre-marketing”: broadly it is defined as information or communications in order to test investor interest in a fund which is not yet established, or established but not yet notified for marketing, and which does not amount to an offer. Within two weeks of beginning pre-marketing, EU managers must send their home state regulator an ‘informal letter’ notifying it of the member states in which they intend to pre-market their fund. It is expected that the same notification requirements will be introduced by most EU member states that currently permit national private placements for non-EU managers, with no changes expected to the position of member states that do not permit private placements.

Where pre-marketing has begun, it will be harder for managers to rely on reverse solicitation. The cross border distribution of funds directive stipulates a “black-out” period: any subscription within 18 months of an EU fund having begun pre-marketing, should be considered to be the result of marketing and be subject to the applicable notification procedures. There is still no clarity from regulators as to whether this would be interpreted to only include investors contacted at pre-marketing or all investors in that jurisdiction. See our separate note on the new rules.

Brexit: Fundraising across the Channel

In a further important change, the new rules restrict pre-marketing undertaken on behalf of an EU authorised alternative investment fund manager (AIFM) to the AIFM itself, an investment firm or tied agent authorised under the EU Markets in Financial Instruments Directive, EU credit institutions and other regulated fund managers. Placement agents and affiliates of the fund manager that are outside the scope of MiFID will be excluded from conducting pre-marketing activities on behalf of an AIFM. The basis of this rule is not completely clear, but presumably reflects a view from EU legislators that marketing (and hence pre-marketing) activities that are carried out with the benefit of the passport and on behalf of an EU AIFM are reserved for EU regulated firms.

This is of concern to firms that house their marketing teams in London and have historically relied on the “passport” to reach investors on the continent. The market is still considering the new rules, which compound the existing fundraising challenges presented by Brexit to UK sponsors and non-EU funds sponsors that conduct marketing activities from outside the EU.

With the EU-UK Treaty agreed, in what was an effectively hard Brexit on financial services, attention has been turned to the EU’s long-awaited equivalence decisions as well as a memorandum of understanding on regulatory cooperation in financial services, the latter scheduled to be finalised this month. Neither is expected to provide a permanent means for UK firms to access the EU. If the EU did eventually make equivalence declarations in favour of the UK, then UK firms conducting fundraising activities on behalf of EU AIFMs will in principle be able to rely on the regime for third-country firms to provide a distribution service to professional clients. As things stand, however, equivalence is unlikely to offer a suitable permanent solution to most firms.